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When a Low P/E Isn't Enough

Sometimes a stock is cheap for good reason -- Matt Richey offers an example.

One of my all-time favorite Fool quotes is Randy Befumo's quip, "Cheap crap is still crap." It's the dilemma faced by every value investor: Most cheap stocks are priced that way for good reason. That's why finding a stock with attractive statistical measures of valuation -- low P/E, low price-to-book, low price-to-whatever -- is never more than a first step towards finding a worthwhile investment.

Why am I raising this point? Because today we look at the first of what I thought would be a handful of promising stocks from the consumer non-cyclical sector. This first candidate, upon closer inspection, turned out quite a bit less promising than it appeared on the surface. So today, instead of a good investment idea, you're in store for what I hope will be at least be a good investment lesson.

But first, a quick review. Last week, as you no doubt recall, I explained why I'm skeptical of a strong economic rebound taking place over the coming year, especially looking out into 2004. As such, I'm generally shying away from economically sensitive sectors -- like retail, financials, and technology -- and instead looking for investment ideas among companies that won't need a strong tailwind from the economy in order to generate acceptable sales and profits. That's what led me to the consumer non-cyclicals, a group that generally has less exposure to the ups and downs of the business cycle.

I left off last week with a promise that over my next several columns I would take a closer look at some "promising" candidates from this sector. As I already hinted, the first candidate has some troubling issues -- albeit with a single-digit P/E to compensate. Whether it's a case of cheap crap is open to debate. Let's take a look and consider the pros and cons.

Enter Department 56The company in question here is Department 56(NYSE:DFS), a designer and wholesaler of giftware and collectibles, including such items as ceramic lighted villages and porcelain figurines. The Eden Prairie, Minn., company has $211 million in sales over the past year and a market cap of $205 million.

What's with the name, you ask? Department 56 was once part of Bachman's, a retail florist in Minneapolis. Apparently, Bachman's used a numbering system to identify each of its departments, and the number assigned to the wholesale gift imports division was -- surprise, surprise -- 56.

Up-front issuesSpeaking of surprises, it seems strange the company is categorized as a consumer non-cyclical when clearly the business of selling knick-knacks makes Department 56 very much subject to discretionary consumer spending and therefore the economy's strength or weakness. Alas, the company's sector categorization seems a bit off, and that's the first knock against it: This is not really a defensive business.

Another problem to be aware of here at the outset is that Department 56's customer base has declined by 19% over the past three years. The company targets its sales to independent gift retailers across the U.S. and Canada. Three years ago, there were 17,400 such retailers; today, there are closer to 14,000. That's still a strong base, but the rate of decline is disturbing.

This loss of customers is making it difficult for Department 56 to grow its sales in any meaningful way. Sales over the past year of $211 million are above the 2001 low of $200 million, but below the 1999 high of 256 million.

A cash machine (but decreasingly so)Despite languishing sales, Department 56 has been a consistent cash generator, with positive free cash flow in six out of the past seven years. In fact, thanks to low capital expenditures, the company's free cash flow has averaged an impressive 17.4% margin over the seven years from 1996 to 2002. Looking at just the past four years, however, the free cash flow margin is somewhat lower at 13.2%.

Maintaining pricing power (until recently, that is)Another positive is Department 56's impressive display of pricing power, seen in the form of stable-to-rising gross margins. In 2002, the company's gross margin reached 56.7%, marking a four-year high. The most recent quarter, however, showed some slippage in pricing, with gross margins falling to 54% from 56% in the prior year first quarter. Management discouragingly noted the cause as "a highly promotional [read: heavily-discounted] retail environment." One quarter doesn't make a new trend, but that's bad news to be sure.

Paying off debt (but piling up receivables and inventory)The balance sheet presents a mixed bag. On the positive side, Department 56 has diligently paid down its debt over the past few years, reducing it from $105 million at year-end 2000 to only $22 million as of the most recent quarter. On the negative side, however, accounts receivable and inventory have both grown much faster than sales over the past two quarters. Like the gross margin issue, it could be temporary, but it warrants a yellow flag.

Perverse management compensationNo more parentheticals -- we're in red flag territory on this one. Department 56 has a bonus structure that in no way aligns rewards with absolute performance. Rather, it rewards its managers for attaining a specified EPS target -- a target that's set at the whim of the board, but likely influenced by management itself (especially considering that the CEO is also Chairwoman of the Board).

The problems here are multiple. First, a bonus based on an EPS target creates all sorts of mis-incentives. Any of the following can boost EPS, while at the same time destroying value: stupid acquisitions, increased debt, poorly timed share repurchases, or sheer accounting gimmickry. Second, this structure pays no attention to whether EPS is actually growing over time; instead, it rewards managers for merely attaining a target, even one that's flat or declining (as has mostly been the case with Department 56).

As the supreme example of what a travesty this compensation structure is, check out the following comparison of CEO and Chairwoman Susan Engel's cash compensation versus the company's operating income:

So, from 1997 to 2002, while operating income declined by 41.9%, Ms. Engel's total cash compensation increased 102.7%, from $597,000 to $1.2 million. Consider too that during this same period of time, shareholders lost 47.6% of their investment.

Meanwhile, option grants are also out-of-control, with this past year's grant amounting to 7.6% of outstanding shares (6.5% net of canceled options). And to top it all off, the company also has a poison pill provision that gives lavish golden parachutes (two-to-three times annual salary) to executives in the event of a change in control.

I've rarely seen such a blatantly self-serving set of compensation policies. As soon as I read the proxy statement, I immediately knew why this stock carried a single-digit P/E: No intelligent investor would ever assign a full multiple to a business like this, where management is essentially the preferred stakeholder. Heck, many intelligent investors wouldn't even consider investing in such a company.

Personally, I don't entirely boycott such companies as an investor, but I do demand a much lower valuation in return for management's lack of proper stewardship.

Cheap crap?Is this a case of cheap crap? The executive pay issue is enough to make me lean that way, but then again, Department 56's stellar cash generation cannot be forgotten. The consistent free cash flow alone is enough to keep me interested -- albeit only at a rock-bottom valuation.

Currently, at $15.60, shares of Department 56 trade for 7.0 times trailing earnings. This year's earnings, however, are expected to decline by 20%, making the forward multiple closer to 9.0. Given all the negatives, that's not cheap enough for me. It'd take a drop to 6.0 times forward earnings before I might hold my nose and give this one consideration.

Department 56 may be statistically cheap, but it's no Hidden Gem. On Thursday, I'll continue my search for true gems (hopefully!) among the consumer non-cyclicals.

Matt Richey (MattR@fool.com) is a senior analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article.The Motley Fool is investors writing for investors.